There Are Still Several Ways for Investors to Get Higher Returns

By TOM PETRUNO

Oct. 2, 1992 12 AM PT

In the game of “how low can you go,” nobody seems able to out-limbo the Federal Reserve.

Get ready for another round: With the economy still sinking, the Fed is likely to cut interest rates again today. If you have a lot of money in short-term vehicles such as certificates of deposit or money market funds, you may soon be staring at 2% returns on your cash. Two percent.

Even for savers who have so far resisted the idea of investing in bonds and other higher-yielding securities, 2% may mark the breaking point.

But take a deep breath: Doing something rash to escape those paltry yields isn’t the answer.

“Living with low money market rates isn’t the worst thing you can do,” says Eric Kobren, publisher of the mutual fund newsletter Fidelity Insight in Boston.

He notes that many disgusted savers cashed in their CDs at the end of 1991 to buy (then) red-hot biotechnology stock mutual funds. The value of those funds has since collapsed 15% to 30%. A 2% return looks mighty good in comparison.

Still, if you want a higher return, there’s time to get it--and at reasonable risk. Here are some ideas:

* Try short-term bond mutual funds. Recommending these funds almost has become a cliche, because they’ve been popular for more than three years now. But they still make sense for investors who need higher income without extreme risk, Kobren says.

Short-term bond funds invest in corporate and/or U.S. government bonds that mature in a few years. The funds yield 5% to 7.5% or more, depending on the quality of the bonds owned.

Wait a minute, you say. What if we’re seeing the last cut in interest rates right now--and the next move is up some time in 1993? If you know anything about bonds, you know that the value of an older bond will drop if new bonds pay more.

That’s true. But the attraction of short-term bonds is that they lose relatively little of their value when market yields move up, simply because you aren’t stuck with those old yields for very long (two or three years at most).

Here’s something else to consider, especially if your goal is higher income, and you don’t care about minor fluctuations in your principal: Money market fund yields now average 2.91%. If you can earn 6% on a short-term bond fund, you’re doubling your return. Even if money fund yields rise 2 points next year, you’ll still have earned more interest in a short-term bond fund at 6%.

The accompanying chart lists three short-term bond funds rated highly by fund-tracker Morningstar Inc. in Chicago. Management fees at all three are very low, so you keep more yield, says Morningstar’s Tom Desmond. And all three are no-load--that is, there’s no sales charge to buy.

Kurt Brouwer, whose San Francisco-based firm Brouwer & Janachowski advises clients on fund investments, suggests that any bond-fund buyer today stick with no-load funds. If you buy a load fund, you clip as much as 5% of your investment off the top--a big penalty, especially if you don’t expect to stay in the fund more than a year or so.

* Buy Treasury notes instead of CDs. Some savers are moving to long-term CDs to earn better yields. But U.S. Treasury notes might make more sense.

The Palm Beach, Fla.-based newsletter Bank Rate Monitor says the average yield on 2 1/2-year bank CDs now is 4.01%. If you buy a three-year Treasury note instead, you can earn at least 4.05%. And while CD interest is taxable at the state level, Treasury interest is not. That’s a big plus in California, with a top income tax rate of 11%.

Treasury notes aren’t tough to buy. Discount brokerage Charles Schwab & Co. charges a flat $39 fee per purchase. Minimum investment: $5,000.

Another idea: Buy U.S. Savings Bonds. Despite their stodgy reputation, they guarantee at least a 6% annualized yield if you hold them five years.

* Shift from taxable investments to tax-free (municipal) securities. If you want to keep your money in a very safe short-term account, you should at least try to get the highest possible return. The best bet now may be tax-free money funds, which invest in short-term IOUs from states, cities and other municipal entities. Interest earned is exempt from federal income taxes.

IBC/Donoghue, an Ashland, Mass.-based money-fund tracker, says the current average yield on tax-free money funds is 2.72%. Because of the tax exemption, that yield is actually worth much more. If you’re in the 31% federal marginal tax bracket, you’d have to earn 3.94% in a taxable money fund to equal today’s tax-free yield.

Because taxable money funds now yield an average 2.91%, the tax-free funds are clearly a smarter investment for many people, says IBC/Donoghue’s Mary Sue Hoban.

What about longer-term muni bonds? You can earn much higher tax-free yields in intermediate-term and long-term muni bond funds, though of course the risk of losing principal value also rises with the bonds’ terms (if market interest rates go up next year).

Still, muni funds are worth a close look, especially by Californians: If you invest in California-only muni funds, interest earned is exempt from both federal and state income taxes. That makes the yields worth much more than their stated value.

Ideas for Desperate Savers

If you’re ready to take on more risk to earn a higher yield than on CDs or regular money market funds, here are some mutual-fund ideas. Most of these funds require minimum investments of $1,000 to $2,500; none charge sales commissions. The corporate/government bond funds listed invest in short-term securities, mostly under three years in term. Also listed are three California municipal (tax-free) funds of varying terms, depending on the risk you’re willing to take.

Corporate/government bonds

Fund/phone number: Current yield*

Scudder Short-Term Bond: 7.91%

800-225-2470

T. Rowe Price Short-Term Bond: 6.54%

800-638-5660

Vanguard Short-Term Corporate: 5.06%

800-662-7447

California muni bonds

Fund/phone number: Current yield*

Scudder California Long-Term: 5.13%

800-225-2470